Decoding the base rate matrix

Sangita Mehta, ET BureauMar 10, 2010, 01.40am IST

Almost a decade ago, K Kannan, the then chairman of Bank of Baroda, mooted the idea that banks be allowed to disburse loans below their prime lending rates — a concept unheard of then, considering that for years banks have been lending at PLR to their best customers and charged a mark-up over the PLR to other borrowers in accordance with the perceived risk. Banks continued to lobby for this (sub-PLR lending) and, after resisting for a while, the Reserve Bank relented.

In its April 2001 credit policy, RBI said, "Keeping in view of the international practice and to provide further operational flexibility to commercial banks in deciding their lending rates, it has been decided to relax the requirement of PLR being the floor rate for loans above Rs 2 lakh. PLR will serve as a benchmark and banks will be able to offer loans at below-PLR rates to exporters or other credit-worthy borrowers including public enterprises on the lines of a transparent and objective policy approved by their boards."

Logic behind the base rate

Nine years after the so-called sub-PLR lending was allowed, RBI now feels that such loans do not augur well for transparency in the interest rate mechanism. Thanks to sub-PLR loan practice, borrowers with better bargaining power could negotiate cheaper rates while others who paid more felt they were cross-subsidising the rich customers. Things have reached a stage wherein nearly 70-75% of loan disbursals are below the benchmark rate leading to some bankers quipping that the PLR had become "MLR" — Maximum Lending Rate — and that a customer could bargain for different rates from two branches of the same bank.

The lack of transparency was not the only reason that prompted RBI to revamp the method of calculating the lending rate. The central bank feared that banks were not pricing their loans accurately. When faced with excess liquidity or under duress to meet lending targets or to maintain client relationship, banks gave loans at a price much below their cost. For instance, short-term loans were given between 4% and 6%, way below their average cost of funds, and they did not incorporate the risk element. Banks justified their stand saying that it was better to lend at 4% than to park money with RBI through the reverse repo mechanism for 3.25%.

Most importantly, RBI felt that sub-PLR lending precluded the pass-through of policy rates to the credit market. After RBI lowered policy rates (following the collapse of Lehman Brothers in September 2008) yields in the g-sec market fell sharply but banks refrained from cutting lending rates. Between October 2008 and December 2009, RBI lowered the repo rate by 425 basis points (bps), reverse repo by 275 bps and CRR by 400 bps. But PSU banks reduced PLRs by 125-275 bps and private banks by 100-125 bps. Lending below PLR could be partly blamed for the failure in transmission of policy rates to the credit system.

To overcome these problems, the central bank decided to revamp PLR and an RBI-led committee suggested that this should be replaced by a base rate — a scheme wherein a bank would arrive at the minimum cost borne on lending and henceforth not lend below that rate. Risk premium would be charged as a mark-up over the base rate.

This would ensure that the bank's overall costs are covered and thereby lead to accurate pricing of loans and result in a transparent mechanism because customers would know at what rate the best customer is actually getting the loan (since no loan can be given below the base rate).